Enron in Perfect Hindsight

December 18, 2001

By Heesun Wee It didn't take long for the Enron implosion to take center stage on Capitol Hill. No sooner did Houston-based Enron Corp. (ENE) file for bankruptcy on Dec. 2 than the search for villains began. The Senate has convened a series of high-profile hearings to delve into the downfall of the mammoth trader of electric power and natural gas. Officials from Enron's accounting firm, Arthur Andersen, testified that Enron engaged in "possibly illegal acts" and withheld valuable information, while Enron maintains it fully cooperated with its auditors.

Some congressmen alleged before the TV cameras that company officials pocketed profits from the sale of stock while engaged in questionable dealings. The Securities & Exchange Commission and the Justice Dept. are both investigating Enron's collapse.

In hindsight, it sure looks as though Enron's top management was asleep at the wheel or had little supervision, as they crafted private partnerships that allowed the company to move millions of dollars of debt off its balance sheet. But truth is, this sad saga has no shortage of culprits -- accountants, the company's board, stock analysts, shareholders, and the press all bear some of the responsibility for not realizing sooner that something untoward was going on at Enron (see BW Cover Story, 12/17/01, "The Fall of Enron").

No doubt the recriminations will go on for months, if not years. But as the number of lawsuits against Enron mount and the energy trader struggles to dig itself out of bankruptcy, the most intriguing question remains: Where was everybody? Indeed, there were so many checkpoints at which those involved in managing and monitoring the company should have blown the whistle, that you almost have to wonder if new laws really are necessary.

Where was management? How many times must it be said: A company chairman needs to stay in touch with his company's business. "Ken [Lay] was responsible, and there's no way to dodge that," says Steve Currall, associate professor of management, psychology, and statistics at the Jones Graduate School of Management at Rice University. And a company board must understand how a company actually works -- and ask questions if it doesn't understand. When a key executive leaves for no apparent reason, as CEO Jeffrey Skilling did last summer, the board and other managers need to investigate to determine if something deeper is amiss.

For the moment, it's unclear how much of a role Skilling may have played in Enron's demise. It does seem obvious, though, that company founder and current CEO Lay was too far removed from day-to-day operations. Managers who reported to him appear to have been busy engineering a financial maze that even Lay couldn't explain clearly.

Where were the auditors? Financial alchemy was behind Enron's transformation from a staid pipeline company to a giant trader of commodities -- a metamorphosis made possible when the natural-gas market was deregulated in the 1980s and the electric-power market opened to competition in the 1990s. Today, Andersen admits that it didn't make the necessary adjustment in its accounting procedures. "We made a professional judgment about the appropriate accounting treatment that turned out to be wrong," Andersen CEO Joseph Berardino testified on Dec. 12 before a joint hearing of two House Financial Services subcommittees (for a Q&A with Berardino, see BW Online, 12/14/01, "Andersen's CEO: Auditing Needs 'Some Changes'").

Granted, Enron's financial structure was a labyrinth. But no matter how complex, it's the job of auditors to be vigilant, especially when the numbers don't add up or make sense. Enron, in a prepared statement, said as soon as it discovered the arrangement that led to questions about the accounting treatment of one so-called special-purpose entity, it immediately notified Andersen. But a closer examination of Enron's books earlier on might have uncovered the problems.

To be fair, auditors could benefit from more rigorous accounting rules. As if Enron's finances weren't complicated enough, no standard procedures exist for reporting on the various kinds of subsidiaries such as those Enron used. "The more clever we get at putting together special-purpose entities, the harder it is to draw particular lines about what's going to be included and excluded" on balance sheets, says Rick Antle, an accounting professor at Yale School of Management. "This issue is a longstanding and long-debated one," Antle adds.

Accounting for a company like Enron is made more precarious because any value placed on an asset -- from a power contract to a pipeline -- is based on assumptions about future power-market prices and volatility. "People are free to make up their own assumptions," says Art Altman of the Electric Power Research Institute in Palo Alto, Calif.

For 20 years, the Financial Accounting Standards Board (FASB), an independent, nonprofit group, has been drafting tougher standards. To say that it's about time for the FASB to move is an understatement.

Where were the analysts and the shareholders? Investors also must share some of the blame for Enron's tumble. They were so in awe of the company's stock performance that many didn't seem to care how it worked. Instead, investors focused on growing trading volumes and revenues. But while Enron remained a trading dynamo, it was investing billions of dollars for physical assets overseas, including a water business in Britain and a power distributor in Brazil, both of which failed to meet revenue expectations. Enron paid more than $1 billion for fiber-optic capacity and trading facilities, but the broadband market crashed.

Stock analysts and credit-rating agencies, meanwhile, weren't much help, as they remained optimistic until the bitter end. On the day before Enron collapsed on Nov. 28, six Wall Street research analysts had a strong-buy rating on the company. The lesson here is that when a company stock looks too good to be true, it probably is. Investors and analysts need to be more watchful and wary.

Where was the press? Let me say it: We in the Fourth Estate missed the boat on this story -- former CEO Skilling's mysterious resignation in August should have been a wake-up call to the media to get to the bottom of the story. Instead, Skilling and Lay were able to convince the press that Skilling was leaving following some vague, personal catharsis (see BW Online 8/15/01, "Jeffrey Skilling's Surprising Split from Enron"). The full story isn't known yet, and Skilling isn't talking, but his reason for a sudden departure is looking mighty suspect at this juncture. The next time a CEO departs without much cause and a chairman can't thoroughly describe a company's finances, the press needs to do more digging (see BW Online, 8/24/01, "Enron's Ken Lay: 'There's No Other Shoe to Fall'").

Now that the Enron story is out, it will continue to unfold for years in the tiniest of details. The debacle will serve as an continuing reminder for other companies. But the revelations come only after investors and more than 4,000 employees lost millions of dollars in Enron stock they had been banking on for retirement. True, if any company wants to hoodwink the world, it can be done. And while it isn't known for sure that anything illegal happened at Enron, many people had many ways to press the company months ago and didn't. For now, that's the most obvious lesson from Enron's fall. Wee covers financial markets for BusinessWeek Online in New York